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All you wanted to know about Employee Stock Option Plan

Maulik Madhu | Updated on August 02, 2021

With the Zomato IPO paving the way for other Indian ventures to consider listing, it’s been raining ESOPs in the start-up world. Farm-to-fork meat company, Licious, rolled out its first ever ESOP or Employee Stock Option Plan early this year. In February, digital payments firm, PhonePe, allotted ESOPs worth $200 million (around ₹1,490 crore) to its employees. Last week, ride-hailing firm Ola announced an expansion of its ESOP pool to ₹3,000 crore in the run up to its listing. Even insurance giant LIC is said to be considering an ESOP ahead of its IPO.

What is it?

ESOPs give employees the right to buy shares of their company at a future date at a pre-decided price. Companies grant ESOPs to their employees as part of their compensation package. While ESOPs have traditionally been granted to senior employees, many firms, particularly start-ups, are now extending them beyond the top echelons.

ESOPs come with an exercise price and a vesting and exercise period. Assume your company gives you ESOPs or the option to buy its shares at an exercise price of ₹50 per share starting a year from now, for two years from there on. The one-year waiting period until you get that right to buy shares is the vesting period. The two-year period during which you can buy them at any time is the exercise period. Once the exercise period is over, you lose the right to buy the shares.

Some companies also grant ESOPs where the vesting period is staggered. An ESOP may be staggered over three years. That is, you can exercise 20, 35 and 45 per cent of your ESOPs at the end of each year from the date of their grant.

Since ESOPs grant you only an option, you can choose not to buy the shares. It may make sense to do this if at the time of exercising the option, the exercise price is higher than the current market price of the shares. Once you have exercised the option, you can sell your shares any time or after the lock-in period specified by the company is over.

As ESOPs are part of your compensation, these are taxed, when you exercise the option to buy and when you make capital gains on selling them.

Why is it important?

ESOPs are intended to give employees a sense of ownership in a company and to work keeping in mind the interests of the company’s shareholders. ESOPs help businesses, particularly cash-strapped start-ups, attract and retain talented people. A significant proportion of the salary at many start-ups may come in the form of ESOPs. While this may imply lower cash in hand for the employees, the potential for windfall gains on sale of these shares at some point in the future makes employees value them.

Why should I care?

ESOPs give employees a chance to buy their firm’s shares at an attractive price. Listed companies may offer these at a discount to the current market price. In its initial stages, an unlisted start-up may grant ESOPs at a very low price to reward those taking the risk of working for a firm when it’s still at a nascent stage. Once the start-up takes off or gets listed, the ESOPs may fetch spectacular returns. ESOPs have made millionaires of many ordinary Infosys employees. The recent bumper listing of Zomato saw the net worth of many of its senior executives with ESOPs zoom in line with the company’s share price.

ESOPs however do have flip side. If the financial performance of the company you’re working with turns out to be subpar, not just your salary but also your wealth will be put at risk. So as exercise your right to buy shares under the ESOP only if the fundamentals of your company are well intact. The taxation aspect too needs to be considered. At the time of exercising the option, you must pay tax on the differential between the fair market value and the exercise price.

Bottomline

ESOPs can bring windfall gains not only for employees but also for the taxman.

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Published on August 02, 2021

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